I’m sure you have heard many times about the power of compounding interest and its influence over long term investments. Even the great scientist, Albert Einstein has termed it as the “8th Wonder of the World”.
Compounding refers to the increase in the value of investments from the interest earned on both the principal amount and accumulated interest. Compounding is a very simple process but takes years of patience and discipline to witness the real effect.
If you can take the power of compounding interest to work in your favour, then your investments will do magic. Naturally attracting more wealth annually than your annual principal amount contribution.
One thing to note here is that the same is also true for liabilities. Debts tend to increases at an increasing rate if not serviced properly, because interest is charged both on the principal amount and accumulated interest.
For this reason, it is said that compounding has the power to make or break someone’s fortune.
In this blog, I will show you the power of compounding using the much popular investment instrument, the Public Provident Fund (PPF). The reason for choosing PPF is because of its total risk-free investment and is one of the most popular schemes for retirement planning.
Almost every nationalised bank offer PPF through their branches and the interest rate on PPF is decided by the Ministry of Finance. I am not going into the technical and eligibility details, as plenty of information is easily available on the internet.
Compounding Interest with PPF
The PPF Calculator is easily available online as a free tool by most banks and fintech websites. It helps to calculate your PPF maturity value allowing you to decide on monthly contribution as per your needs.
In this example, Let’s assume you are 25 years of age, determined to continue the PPF investments till 60 years of age ( the max limit) with a monthly contribution of Rs 5000.
The interest rate payable is 8.10 per cent.
So, here the maturity value after continuing it for 35 years comes in at Rs 1,26,64,292.
Breaking up the maturity value, the principal amount contribution is only Rs 21 Lakh, which is only 16.58 per cent of the total maturity value.
So, now if we assume you are 30 years of age and makes a monthly contribution of Rs 8,500, so after, continuing the investment for 30 years, the maturity value is Rs 1,37,68,015. The principal amount contribution, in this case, is 22.22 per cent.
|Scenario 1||Scenario 2|
|Monthly Contribution||Rs 5,000||Rs 8,500|
|Maturity Value at Age 60||Rs 1,26,64,292||Rs 1.37,68,015|
|Total Principal Amount and Percentage||Rs 21 Lakh or 16.58%||Rs 30,60,000 or 22.22%|
Comparing both the scenarios, we can see the huge difference when you start your investment cycle early and how effectively the power of compounding works in your favour. Despite 70 per cent higher monthly contribution in scenario 2, we can see that the maturity value is just 8.7 per cent higher compared to scenario 1.
As we have witnessed through the above scenarios, compounding interest can create millionaires out of average people and acts as a friend if you are poor.
Compounding interest is not just applicable to PPF, it is applicable to mutual funds, stocks etc. You can explore how compounding works with other market traded instruments.
So, Start Early, Invest Rightly and Create Wealth.